Boston - Late last Friday and over the weekend, the House Ways and Means Committee released draft text of the reconciliation bill — to be known as the Build Back Better Act. On Tuesday, discussion resumed on this part of President Biden's economic agenda as the legislative process continues.
In this blog we highlight some spending and tax provisions of the proposed reconciliation bill and their potential impacts on the municipal market.
The total spending provisions in the reconciliation bill equal $3.5 trillion over ten years. At a very high level, this breaks down to $1.2 trillion in additional safety net spending, $850 billion in health care spending, $540 billion for education, $450 billion for clean energy and $425 billion for housing.
Here are two of the biggest spending provisions that could impact the municipal bond market:
Advance Refunding Bonds. The bill would reinstate tax-exempt bonds for advance refundings, which were eliminated as part of the 2017 Tax Cut and Jobs Act. In the five years before 2017, tax-exempt advance refundings accounted for roughly 25% to 30% of total tax-exempt bond issuance annually. With the elimination of tax-exempt refundings, much of this volume migrated to taxable municipals, which hit a record of $146 billion in issuance last year.
The reinstatement of advance refundings would lead to additional tax-exempt supply relative to taxable issuance and could also improve municipal credit quality, as borrowing costs would be lowered.
New Direct Pay Qualified Infrastructure Bonds. The House bill would revive Build America Bonds (BABs), which were created by the Obama/Biden administration in April 2009. The BABs program offered a 35% subsidy directly to issuers of taxable municipal bonds, and was responsible for $181 billion in taxable muni issuance before expiring in December 2010. The new BABs program would offer subsidy rates of 35% in 2022, which would decline to 28% in 2027 and thereafter.
This program could lead to more taxable issuance and potentially broaden the buyer base of municipals (including foreign buyers), which could help to stabilize the muni market in times of stress.
The House intends to pay for the spending initiatives through a combination of $600 billion in revenue from dynamic scoring growth estimates from the bill, which is part of the reconciliation process, as well as $700 billion in savings from drug price controls, $200 billion from tax enforcement revenue and approximately $2 trillion in tax increases.
Here is a summary of some individual and corporate tax increases in the House proposal that could drive additional interest in tax-exempt municipal bonds:
Increasing the top individual income tax rate to 39.6% from 37%. Importantly, the higher 39.6% tax rate will kick in at income levels of $400,000 for individuals and $450,000 for married couples — down from $523,600 and $628,300, respectively, under current law. Including the 1.45% Medicare payroll tax and the 3.8% surcharge on investment income, the top federal income tax rate would be over 40%. This proposal is expected to raise $170 billion over ten years.
Adding a new 3% surtax on income over $5 million. This proposal is expected to generate $127 billion in revenue over ten years.
Increasing the capital gains tax rate to 25% from 20%. This proposal could raise $123 billion over ten years.
Increasing the corporate tax rate to 26.5% from 21%. Applying only to businesses with income in excess of $5 million, this proposal could raise $540 billion over ten years. Additional corporate tax increases on overseas income and broadening the base of corporate taxes could raise another $400 billion.
We think it is unlikely that the $3.5 trillion in spending and $2 trillion in tax increases outlined in the reconciliation bill will ultimately become law, as Democratic Senator Joe Manchin has stated that he will not vote for $3.5 trillion in new spending.
Bottom line: In its current form, provisions of the bill could result in additional tax-exempt issuance, which could be offset by higher demand for municipal bonds due to higher tax rates. And while the return of tax-exempt advance refundings may slow the current surge in taxable issuance, the reinstatement of the BABs program would most likely counteract any decline in taxable refunding volume. If both tax-exempt advance refundings and BABs are revived, that would be the best outcome for the muni market in our view.